Ronald Coase tribute

As I am a former University of Chicago Law School professor, who overlapped with Ronald Coase during my eight-year stay there, I was asked a couple of years ago if I would like to join a group of people who would be writing short tributes to Coase, for a volume to be published by the U of C Law School, via the Coase-Sandor Institute for Law and Economics.  Now that the volume has come out, here is my little snippet.

The Coase Theorem and the Two Fundamental Theorems of Welfare Economics

                                                                                                Daniel Shaviro*

Both the Coase Theorem and the two Fundamental Theorems of Welfare Economics are well-known.  Less widely recognized, however, is their close intellectual relationship, which helps us to understand the nature of one of Ronald Coase’s main contributions.

The First Fundamental Theorem of Welfare Economics holds that a competitive equilibrium, where supply equals demand, maximizes social efficiency.[1]  The Second Fundamental Theorem of Welfare Economics holds that society can attain any efficient outcome by suitably redistributing resources among individuals and allowing them to freely trade.[2]

Two different ways of stating the Coase Theorem help to make clear its relationship to each of these propositions.  First, suppose we state it as follows: “When there are well-defined property rights and costless bargaining, the negotiations between the party creating the externality and the party affected by the externality can bring about the socially optimal market quantity.”[3]  This is basically the First Fundamental Theorem, supplemented by the point that all a market requires is well-defined property rights that can cheaply be transferred.

Now suppose we state it as follows: “The efficient solution to an externality does not depend on which party is assigned the property rights, so long as someone is assigned those rights.”[4]  This is basically the Second Fundamental Theorem, again with the added point that distributable “resources” can include property rights with respect to the creation of externalities.

The two Fundamental Theorems of Welfare Economics predate the Coase Theorem by many decades,[5] and surely were well-known to the “room full of skeptical Chicago economists – including future Nobel laureates Milton Friedman and George Stigler”[6] who debated it with Coase on that famous evening when he first presented his reasoning.  What, then, was actually novel about the Coase Theorem?

The answer, I believe, lies in its extending the Welfare Theorems’ range of application.  Rather than applying just to readily observable markets for consumer goods in the field of organized economic production, they can apply wherever their basic underlying assumptions hold.[7]  Coase understood that the right either to engage in or to block polluting activity could be just like ownership of a widget.  And a “market” could be understood as any setting where people have well-defined property rights that they can transfer through low-cost transactions.[8]

Coase was thus a prominent early mover in one of the major developments of the last fifty-odd years in law and related social sciences: the steady expansion of the realm of neoclassical economic reasoning. To be sure, even before Coase, pollution was well-understood to involve “economic activity” that called for an “economic analysis” of government policy responses.  Later decades would see economists ranging considerably further out of their ancestral realm of studying organized economic production.  Consider, for example, Gary Becker’s Treatise on the Family,[9] applying neoclassical economic reasoning to study of the household, or Richard Posner’s The Economics of Justice,[10] taking “an economic approach to issues – including the meaning of justice, the origin of the state, primitive law, retribution, the right of privacy, defamation, racial discrimination, and affirmative action – that are not generally considered economic.”[11]  But Coase was an early mover, important not just for how he advanced the economic analysis of externalities, but also as a pioneer and harbinger of economic reasoning’s broader future.

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* Wayne Perry Professor of Taxation, NYU Law School.

[1] See, e.g., Jonathan Gruber, Public Finance and Public Policy 50 (4^th ed. 2013).

[2] Id. at 53.

[3] Id. at 130.

[4] Id. at 131.

[5] They were first set forth by Pareto in 1894.  See John S. Chipman, The Fundamental Theorems of Welfare Economics (2002), available on-line at http://www.econ.umn.edu/~jchipman/econ4960/ftwe2_all.pdf .

[6] Sarah Galer, Ronald Coase Still Stirs Debate at 101 (2012), available on-line at http://www.uchicago.edu/features/20120423_coase/.

[7] For example, “[t]o establish the First Theorem, we need to sketch a general equilibrium model of an economy.  Assume all individuals are price takers: none is big enough, or motivated enough, to act like a monopolist.  Assume each individual chooses his consumption bundle to maximize his utility, subject to his budget constraint.  Assume each firm chooses its production vector, or input-output vector, to maximize its profits subject to some production constraint.  Note the presumption of [rationally pursued] self-interest.  An individual cares only about his own utility, which depends on his own consumption.  A firm cares only about its profits.”  Allan M. Feldman, Welfare Economics, in John Eatwell, Murray Milgate, and Peter Newman (eds.), The New Palgrave Dictionary of Economics, 4: 889 (1987).

[8] Coase’s notion of transaction cost can be viewed as underlying the existence of a well-functioning market.

[9] Gary S. Becker, A Treatise on the Family (1981).

[10] Richard A. Posner, The Economics of Justice (1981).

[11] Id. at 1.